Lack of Liquidity and Firesales

The real estate people like to talk about “location, location, location.” As traders you should almost always be constantly thinking about “liquidity, liquidity, liquidity.”

Most traders, especially retail traders don’t think about liquidity. They believe they don’t have a need for it. After all, if they are placing small orders of 100,000 or 300,000 currency units, then the broker can surely find liquidity for such small orders and fill them? Right?

As a general rule, during normal market conditions they can. But during extraordinary market conditions you can get slipped on your orders, sometimes slipped very badly. And the volatile conditions just seem to be happening more and more often.

There were plenty of traders who were short EUR/CHF going into the September 6, 2011 announcement that the SNB was going to peg the franc to the euro at 1.2000. The market started gaping higher 50 – 100 pips per minute. There was not enough liquidity to fill all the stop loss orders. People could of gotten slipped 50 pips, or 500 pips or more.

Which is why you always need to be thinking about liquidity, even with small accounts. Not only can it help you reduce the chances of blowing an account, and preventing catastrophic losses, but it also can open your mind to various new inefficiencies in the market.

Liquidity

The importance of liquidity does not just apply to the forex market. It applies to every market, everywhere. Whether it is stocks, bonds, commodities, real estate, etc.

In 2008, there were many banks holding toxic assets of various mortgage related securities and investments. Much of the tens of billions of losses incurred by the banks and investment houses were a result of massive housing exposure gone bad.

Not only were they holding tens of billions, and hundreds of billions of a declining asset. That is bad enough.

What is worse is when there is no liquidity to bail out of your position. When you own billions of assets or trades that are declining in value, and there is no liquidity, then you are in trouble.

Here is an example of liquidity and order flow principles in action back in 2008:

Merrill Lynch had long exposure to $30 billion worth of CDO’s (collateralized debt obligations). Just think of them as being long the housing market. When the market collapsed there were very few bids in for those types of assets. There were very few bids in and plenty of sellers willing to hammer the price down and hit any bids that were lower. Thus the prices for these assets were declining.

As the $30 billion worth of CDO’s were depreciating in value they were causing billions of dollar of loses to the holder of them, which was Merrill Lynch. I am fairly certain they were attempting to unload them slowly without moving the price against them. It was probably proving difficult for them to dump that much worth of the assets without moving the price against them drastically. Even if they could find buyers it may have only been for small portions of the CDO’s. Maybe $100 million here, another $100 million there. They could not unload all of them like they wanted.

Therefore, what John Thain decided to do was to sell it all – to one buyer. To unload them all and sell them at the same time. Now in order to do this, they need to find a willing person on the other side to provide liquidity. They also recognized that when you dump that many assets onto to one person, they will need to provide a discount to the buyer – a very big discount.

From the business week article:

You’ve made some extraordinary moves in the past week, selling more than $30 billion worth of CDOs [collateralized debt obligations] for the bargain price of $6.7 billion, or 22¢ on the dollar, compared with the 36¢ you valued the securities at just a quarter before. Why take this hit and do the sale immediately?

The buyer bought $30 billion worth of CDO’s for only $6.7 billion dollars, which is 22 cents on the dollar.

The reasoning gave by John Thain was because:

John Thain: This sale of CDOs is a huge move in reducing the risky assets on our balance sheet. It’s a continuation of the process we’ve been going through for the past seven months, but it’s most significant in that these assets and their related hedges represent approximately 70% of all the losses that we’ve taken over the past 12 months. And the ability to get this sale done in one bulk trade to a single buyer, where there has been almost no liquidity in this marketplace, made sense for us both to reduce risk and eliminate the overhang of continued losses from asset devaluations.

He dumped it all in one bulk trade to a single buyer because there was no liquidity and he wanted to staunch losses and reduce risk.

John Thain was asked why did he dump them for 22 cents on the dollar:

Bartiromo: Is it fair to say the price is 22 cents on the dollar today?

Thain: I can only say that the price was 22 cents on the dollar to sell $30 billion worth to a single buyer in a single trade.

And there you go folks. Thain wasn’t sure if a fair price as 22 cents on the dollar. All he knew was that he wanted to bail out of $30 billion worth of toxic investments, and the only liquidity he found for a bulk trade in that size was at 22 cents on the dollar. They found that limit bid at 22 cents on the dollar and completed the transaction.

Not only that, but Merrill Lynch had to finance 75% of the purchase price. The buying of the assets at 22 cents on the dollar was not enough to entice the buyers and complete the deal. Merrill had to loan the buyer money to take the toxic assets off its own books!

Can you imagine that?

Lets say you are holding $1 million dollars worth of a stock. The price drops to $700,000 and you want to dump your whole position but there are very few bids. You find a buyer for all your stock. You are willing to sell the stock for $500,000 which was previously worth $700,000. But that discount was not enough. You had to lend the buyer $375,000 so they could buy the assets (stocks in this case) off of you.

You just want to get rid of the assets and take your loss and stop the pain. But the only way to do so was to offer a big discount and to lend money to the person who is going to buy them from you. Now that tells you how desperate some of the sellers were back in 2008.

The key words are fear and desperation. They just want to get out at any price. They don’t care what price they get, they want to staunch the losses and stop the pain.

Bruce Kovner: To this day, when something happens to disturb my emotional equilibrium and my sense of what the world is like, I close out all positions related to that event.

The people who were long the housing market back in 2007 and 2008 had taken so many losses and had their emotional equilibrium so disturbed that they wanted to close out all positions related to those trades. And to do so, some of the had to accept even bigger losses in the process of liquidating the positions.

Forex Application

Now you may ask, this is nice, but how does it apply to forex?

Every time the market makes a big move, of a few hundred pips, or thousands of pips there is always an element of someone stuck on the wrong side of the market that needs to bail out of their position.

When AUD/USD drops 1,000 pips within seven days, I can assure you there was a lot of terror felt by the people holding tens of billions of dollars worth of AUD/USD longs. Their emotional equilibrium was disturbed and they wanted to get out – either through stop losses or just dumping them into the market.

When EUR/USD dropped 300 pips within 24 hours on September 9, 2011, a similar situation happened. Very few limit bid orders, while everyone else wants to just bail out.

When a currency pair makes a big move there may not be a single person holding $30 billion worth of the currency pair. But you can bet that a combination of market participants were holding billions, and tens of billions worth of a currency pair, and they all together, in unison want to bail out and thus creating the big market moves. It is a combination market participants holding the large positions.

Figure out what would cause them to initiate such a liquidation. For there exists massive profit in knowing when they will occur.

The technical indicator trader does not think about the market in terms of order flow and liquidity. They are just looking for their MACD’s and moving averages to line up. They are looking for the divergence and overbought, oversold signals.

The chart pattern trader does not think about the market in terms of order flow and liquidity. They are just looking for their head and shoulders, double top, triangles, etc.

The price pattern trader does not think about the market in terms of order flow and liquidity. They are just looking for their pinocchio bars, engulfing bars, fib retracements, support and resistance, etc.

The forex robot trader does not think about the market in terms of order flow and liquidity. They are looking for the hot new expert advisor to test in metatrader. They are looking for the forex robot to give them the signals.